Remarks by Former Fed Chairman Paul Volcker

October 4, 2007

Speaker
Paul A. Volcker, Former Chairman of the Board of Governors of the Federal Reserve System

Presider
Alan Blinder, Gordon S. Rentschler Memorial Professor of Economics and Co-Director, Center for Economic Policy Studies, Princeton University

On October 4, 2007, former Federal Reserve chairman Paul Volcker spoke to Japan Society about financial market crises, from silver to subprime, and his perspectives on central banking and regulation today.

Presider Alan Blinder of Princeton, former Fed vice chairman, asked, “At the Board of Governors, when a financial crisis erupts--on a spectrum from this is just business-as-usual-plus, to man-the-battlements--what does it feel like?”

Mr. Volcker responded, “It’s a little different when you’re down there and have to act or not act. I mean, the decision often is whether not to act at all. And you feel a little embattled, I guess is the right word.”

“The first crisis I met as Fed Chairman —this has long since been forgotten - was something called the silver crisis with the Hunt brothers in Texas who were actually monopolizing the silver market at one point,” he continued.

“I was sitting in a board meeting one morning—this was not the center of my attention, but I was told I had an urgent call from a major Wall Street house and I had to take it.”

“And I took it then or a few minutes later and they told me, we’re going to go bankrupt unless you do something about the silver market. Because at that point the silver market was going down and all these margin loans were coming home to roost. So, I got interested in a hurry.”

Mr. Volcker called the head of the Commodity Futures Trading Commission and said, “‘hey, you’ve got to tell me who owns what and what’s going on in this market.’ And he told me, ‘I can’t tell you, it’s confidential.’ Which was not much of a--”

He paused.

“We have a lot of regulators in America,” remarked Mr. Blinder.

Mr. Volcker chuckled and continued:

“Anyhow, this incident came to mind, because at that point, in consultation with the Treasury, the plea was to close the market, to give the exposed firms time to liquidate these silver positions without the price going down. We didn’t have any legal authority to do it, but maybe we could have asked those with authority to close it.”

“But we decided not to ask the market to close. It was a decision not to do something. And the next day it so happened the price stabilized and that particular firm managed to escape its last position relatively unharmed.”

“There were quite a few repercussions from the crisis elsewhere, but that particular firm escaped.”

“What irritated me was some months later after calling me up and telling me they were about to go bust, they had a full-page advertisement in the New York Times, ‘the most profitable quarter in all our history.’”

On the situation with subprime mortgages, Mr. Volcker said that “you’re caught in something of a trap, because you have a severe problem in the markets brought about by the market’s own excesses in some sense and you don’t want to rescue those responsible and give rise to further bubbles and further inappropriate behavior.”

“If you fully protect the economy, you’re feeding bubbles. If you let it die its proper death, you may be hurting the economy.”

“So, there is no right answer or no clearly right answer. In between you make the best judgment you can and go ahead.”

“You have one instrument, you have one clear instrument, and that’s interest rates, a pretty blunt, general instrument. You can talk, you can exert moral suasion or whatever,” he added.

“I’ve now been out of government for 20 years—actually just about 20 years, a long time.” Kids in college now “study the 1970s like it’s the Second Punic War, I think.”

Derivatives and securitization existed then, but weren’t much used; “commercial banks were the major suppliers of credit, including the thrifts.”

“They did the intermediation, they took short-term money and made longer-term loans and they were regulated and supervised. And there was kind of a quid pro quo. We’ll protect you when you get in trouble, to a certain extent anyway, but you’ve got to be regulated.”

Now, commercial banks “are much less important, as institutions, and what’s grown up is an unregulated, pretty much unregulated, surrounding of various financial operators.” Some are investment banks; some are “institutions that call themselves commercial banks, but they’ve been trying very hard not to be commercial banks recently, instead getting into all kinds of investment banking, investment management—on and on—trading activity, which used to be no-no for commercial banks. Quite a different world.”

“And at the same time what used to be called banks and are still called banks have tended to get much bigger, at least at the core—a dozen institutions around the world that are huge relative to what we used to think of as even big commercial banks.”

“Now, why is that? I think it’s, whatever they say, it’s kind of an instinct, the bigger the better, the bigger you are, the safer you are, and the more diversified you are, the better off you are. Beyond a certain point, there is no evidence of any real economies of scale in this business, but there’s an economy of comfort I think when you feel diversified and you feel big.”

“So, on the one hand we have this very opaque, difficult to understand, rapidly changing marketplace, and a few, big, commercial banks behind it, and nobody wanting to do the traditional commercial banking business of making and holding loans. I’m exaggerating in all this just to give you a general picture.”

“So, what goes on? A couple of interesting things.”

“We have this crisis out of, kind of out of nowhere. I don’t follow this that closely, but I had no idea that this subprime mortgage business had become as big as it is.”

“Alan Greenspan said the same thing,” commented Mr. Blinder.

“The difference is he should have known and I didn’t, I’m just reading the newspapers,” Mr. Volcker shot back with a twinkle.

Then, he continued, “when people lost confidence in their ability to buy or sell packages of these subprime mortgages, lo and behold it turned out that to a considerable part they were financed by short-term money,” commercial paper that couldn’t be rolled over because of the loss of confidence, “what could they do? Well, they had to run to the banks.”

“And suddenly banks were important again. These institutions, these archaic institutions that people, including the banks themselves, were trying to get rid of, kind of without thinking much about it provided backup lines for all these other people at some miniscule cost, because they didn’t think they’d ever be called. But suddenly they became important institutions,” in part because of their access to central bank money.

“When you look at it now, I’m told that the pressure seems to be subsiding a bit,” but “it’s been a pretty good test of this new market.” The implications for the future remain uncertain, he observed. “Suppose this discomfort with a trillion and a quarter of subprime mortgages took place when let’s say you were having a little recession—not even a big recession?”

“These banking conglomerates are so big--the central institutions--and the others are so free wheeling that it’s very difficult to think there’s a supervisory and regulatory system that’s going to deal with it.”

With securitization dominating the mortgage market, a relative minority of mortgages “are actually held by the originators,” Mr. Blinder observed. “And I know you’ve thought about this and talked about the kind of incentives or lack thereof for due diligence created by that quite valuable innovation.”

Mr. Volcker responded:

“This started back in ancient history when I was still in the Federal Reserve in a nascent kind of way. But I can remember the principal banking regulator in the Federal Reserve—the top staff guy, who was an exceptionally strong man. A strong supervisor, intelligent, knowing and he actually came out of the real estate business when he was a young man. I could never believe how cynical he was about some real estate.”

“But apart from that, when this started he said look, if the banks are going to sell these loans as soon as they make them, they’re not going to pay attention to the credit. So, this was perfectly foreseeable. I’m sure he’s not the only person that foresaw that. But it was foreseen at that time.”

“But the pressures to do it were so strong, and any regulator at that point who’d said, no, we think this will lead to weaknesses in the structure over time and it won’t be sufficiently disciplined, we’re not going to permit you to originate and sell those loans, and we’re going to throw some sand in the wheel so this market doesn’t work--you would have been ridden out of town.”

“This crisis ought to help a little bit to restore discipline. I say a little bit, because we are at the second or third derivative of ownership and repackaging. You don’t know what you’re buying. So, it’s hard to put pressure on the guy that originated the loan when you don’t even know who he is.”

“I think for a while, people will be more cautious. Among other things, it brings up the role of the rating agencies, which is a popular subject these days and I’m not sure there is a clear answer to that.”

“What does the experience of Japan in the last 15 years tell you about the evils or lack thereof of deflation--which is not a problem you were thinking about much when you were heading the Fed,” asked Mr. Blinder.

“Well, you’re right,” Mr. Volcker replied. “The deflation is not a matter that’s caused me many sleepless nights. In fact, I don’t think I’ve ever had one sleepless night worrying about deflation.”

“And I do think the Japanese experience is misread,” he added. “I think kind of a myth arose that because prices were going down by 1 percent a year, Mrs. Watanabe was not spending. Now, I don’t have the vision that the Japanese housewife or the Japanese whoever is sitting around saying, I’m waiting for prices to go down 1 percent next year, so I’m not going to buy. I just don’t think that was what drove this long period of relative stagnation. What drove the thing was the enormous losses in financial value when you had this huge deflation in both real estate and the stock market. And it took a long time to recover from that.”

“Talk a bit about your views of the role again, or lack thereof, of the central bank and bursting bubbles before they burst naturally,” said Mr. Blinder.

“This business in the UK is really interesting--they have one institution,” mortgage lender Northern Rock, “that was really stuck. And it was palpable that the Bank of England didn’t want to do anything about it, and said so for a few days,” Mr. Volcker commented.

“But then they finally decided they had to and once they did something – providing a deposit guarantee - with that one institution they were worried about the repercussions in other institutions,” so they announced that “if there’s any other institution in the same difficulty we will guarantee their deposits as well.”

“That’s a pretty radical—there are a number of things that have gone beyond my imagination when I was in office, but the idea of guaranteeing all the bank deposits in the United States never passed my mind. And now they’ve done it at least for the moment.”

“You can tell in reading some of the reports, that the Governor of the Bank of England is worried about, now they are in this, how do they get out? And that’s a situation you don’t want to be in, where de facto you suddenly are nationalizing--to make an extreme statement--I take that statement back,” Mr. Volcker said humorously. “But when you make such a sweeping guarantee, what are you doing for the future?”

Q&A with the audience followed:

I’ve read a number of things about your successful containment of inflation and one of the ideas is that you utilized the monetarist framework to target money. Some people say that actually that was just an excuse for you to raise rates. Did you have a target, a money target, and if you didn’t target M1 or M2, could the Fed do it today?

“It is much more difficult to control, within the short run I believe impossible, either M1 or M2, to the degree that the active monetarists thought you could,” responded Mr. Volcker.

It wasn’t a ruse to raise interest rates, he continued. “We had no idea where interest rates would go or could go.”

However, “the core of the monetarist’s doctrine, you know, makes some sense, too much money chasing too few goods,” and it was a concept that the public could understand, and also a way “to discipline ourselves, so that we couldn’t slide into what had been the practice--of money spikes a little high, we’ll raise interest rates a little bit and hope that it comes down, and you keep kind of fooling yourself or at least not sufficiently disciplining yourself.”

“So, we were always interested in interest rates, but we approached it somewhat indirectly, even when we were most concerned about interest rates, by picking some other immediate target, and we felt the market reasction was giving us some information. And typically you would force the banks to borrow at the Federal Reserve if you wanted to tighten money. And the way the interest rate responded, you knew it was going to be up if you forced them to borrow. But how far up, how quickly it went up, how it affected their behavior, I still think carries some information that we’ve lost by just saying the interest rate will be 4¾ percent up or down two basis points.”

“Well, you and I have disagreed on this before,” said Mr. Blinder.

“That’s why I gave such a long lecture so you could breeze by,” laughed Mr. Volcker.

Alan Greenspan has expressed the view that the next big move in interest rates is upwards, with perhaps the prospect of an 8 percent long bond rate in fairly short order; and today Bill Gross announced that we are experiencing the last fixed income bull market of his career. A question to you both--would you agree or disagree with Alan and Bill?

“I don’t see that as any inevitability,” Mr. Volcker said, but he urged continued watchfulness. “If it’s okay to have 2 percent or 3 percent inflation, it’s very hard to marshal restraint against 4 percent, because there isn’t that much difference. And once you get accustomed to 4 percent and it goes to 6, are we going to make a big deal over the difference between 6 and 4?”

“It’s not an immediate problem, but are you going to get caught up in a kind of cycle or a trend that’s going to end you up with something that’s troublesome,” something big enough to affect behavior.

“I’m very much less worried,” for three reasons, commented Mr. Blinder: India, inertia, and inflation targeting. Disinflationary pressures on service prices, coming from India and elsewhere, are in their infancy; “there’s a tremendous amount of inertia in the system,” and since inflation worldwide is low (aside from Zimbabwe), “the inertia’s working for you”; and “more and more central banks are converting over or already have converted over to either actual inflation targeting or,” as with the Fed, “closet inflation targeting,” where the difference, say, between 2 percent and 2.5 percent is taken very seriously.

In terms of the subprime crisis and these second-, third- and fourth-generation risk-allocation mechanisms, does the solution lie in more transparency in the system, or more regulation?

“You’ve always had this cleavage between the banking regulators,” who worry about safety and soundness, and the SEC, which worries about transparency and disclosure. “The range of institutions that is regulated primarily by the SEC and the CFTC somehow has to come under a greater tent of regulatory apparatus that’s concerned about the safety and soundness of the whole system,” perhaps building on the approach of Gramm-Leach-Bliley, Mr. Volcker responded.

“I think the only time there’s any support for regulation and supervision is when things have gone bad, and that is not most of the time. Most of the time the impressions are all in the other direction and it’s very hard to maintain regulatory discipline. And I’ve always thought the only agency, just to be blunt about it, that you can count on more than others to maintain the discipline, is the Federal Reserve. Simply it’s the most independent, the strongest, the most prestigious-- And without that, it’s very tough.”